Strategies for Retirement Accounts
By Cowles Liipfert
With less than 1% of taxpayers now being subject to federal estate tax under the new tax laws, the emphasis for tax planning for most of us has shifted from estate tax planning to income tax planning. Many people have retirement accounts of sufficient size to warrant more attention to income tax planning for those assets.
A participant’s retirement account is funded with tax-deductible contributions during his or her high earning years, presumably when he or she is in a higher income tax bracket than after retirement. By making contributions during a participant’s high-earning years, the participant not only delays the payment of taxes on the contributions, but also is likely to have lower tax rates when distributions are later made.
The participant gets tax deductions for contributions to the account, and the account builds value tax-free until distributed. Maximum funding of a retirement account during one’s working years is usually a very effective tax planning technique.
DISTRIBUTION RULES DURING OWNER’S LIFETIME
With a traditional IRA, the owner has to begin taking required minimum distributions (RMD) for the calendar year in which he or she reaches age 72, by April 1 of the following calendar year.
Prior to the adoption of the “Setting Every Community Up for Retirement Enhancement” (SECURE) Act in December 2019, the required beginning date for IRAs was April 1 of the year after which the IRA owner attained age 70½. The old rule is applicable through 2019, but not to 2020 or later years. Under the old rule, if the IRA owner’s birthday was on or before June 30, the required beginning date would be April 1 of the following calendar year, but if his or her birthday was on or after July 1, the required beginning date was one year later, also on April 1. The new rule under the SECURE Act makes April 1 of the following year after you attain age 72 as the required beginning date, no matter whether your actual birth date is in the first six months or the last six months of the year.
There is a “uniform lifetime table” whereby the RMD or required minimum distribution is determined, based on the life expectancy of the account owner and the life expectancy of a second person who is 10 years younger, but if a taxpayer is married to a spouse who is more than 10 years younger, the account owner may use a “joint and survivor table,” based on the taxpayer’s age and the actual age of the younger spouse. The Life Expectancy Factor under the uniform lifetime table for an IRA owned by for a person who is age 70, is 27.4 years; for age 80 is 18.7 years; for age 90 is 11.4 years; and for age 100 is 6.3 years. The reason those life expectancies seem so long is because they are based on the life expectancies of the second to die of two lives, using 2-life tables, based on the age of the account owner and the age of a person who is ten years younger.
Please be aware that the uniform lifetime table applies to every IRA owner (not including owners of “inherited” IRA accounts), except someone with a spouse who is more than 10 years younger. It applies to someone with an older spouse, to someone with no spouse, and to a participant who has not named a beneficiary at all for his or her retirement account. It also applies to someone who has designated his or her children, grandchildren, or others – except for a spouse who is more than 10 years younger – as beneficiaries of his or her account.
Distributions from an IRA or qualified plan before the taxpayer reaches age 59½ are ordinarily subject to a 10% early withdrawal penalty, but there are exceptions to the general rule: If the IRA owner qualifies as a first-time homebuyer, for example, he or she can withdraw up to $10,000, penalty-free, to use as a down payment or to help build a home. With the cost of higher education spiraling, people are also allowed to turn to their IRAs to help pay certain college expenses, penalty-free, from their IRAs – for tuition, books and other qualifying expenses – as long as the student (you, your spouse, your child, or your grandchild) is enrolled more than half-time at an eligible educational institution. Distributions for those purposes are not subject to the 10% early withdrawal penalty, but they are subject to regular income tax.
Early withdrawals also may be allowed penalty-free through a “Substantially Equal Periodic Payment” (SEPP) plan, with specified annual distributions for a period of five years or until the account-owner reaches age 59½, whichever comes later. Again, income tax must still be paid on the SEPP withdrawals, but no penalties. A SEPP plan is best suited to those who need a steady stream of income prior to age 59½, perhaps to compensate someone whose career has ended earlier than anticipated.
SEPP plans can be boons to those who need access to retirement funds earlier than age 59½, but starting a SEPP early – or even withdrawals for educational expenses or for a down payment on a new home – will have implications for your security later, in retirement. If you spend the money now, it will not be available when you are older. Before you embark on a SEPP plan, you should get the advice of your financial planner.
DIRECT TRANSFER FROM IRA TO CHARITY
If you are fortunate enough that you do not need your IRA distribution for living expenses, and if you are charitably inclined, you can avoid income tax by making a direct distribution from your IRA, up to $100,000/year, to a charitable organization. This is called a “Qualified Charitable Distribution” or QCD. If you file a joint income tax return and if your spouse also has an IRA, your spouse can also make a QCD of up to $100,000 from his or her IRA, which will not be taxable on your joint tax return. The gift will also reduce the value of your IRA account, thereby reducing your required minimum distributions (RMDs) in the future.
QCDs may be made only from IRAs – not from 401(k)s or other similar retirement accounts – but you can roll over funds from a 401(k) account to an IRA, then make the gift from the IRA to the charity. This takes extra time, and you must meet the deadline (usually December 31) for completing the charitable gift.
The charity to which you make the gift must be a 501(c)(3) organization, eligible to receive QCDs, but may not be (a) a private foundation, (b) a “supporting organization,” which is an exempt organization which carries out its exempt purposes by supporting other exempt organizations, or (c) a Donor-Advised Fund of “sponsoring organization,” which is a public charity which accepts and manages such funds, and from which distributions may be made to other charitable organizations, as recommended by individuals or families.
Please note that the QCD is not included in your taxable income, so you cannot claim an itemized charitable deduction for your gift on your income tax return. Otherwise, you would be getting a double benefit, i.e., (1) the distribution to charity would not be taxable income on your tax return, and (2) if it had been deductible, you would also get an itemized charitable deduction on your tax return. That would be too good to be true and is not allowed. However, you can still claim a standard deduction on your personal return – not an itemized charitable deduction – in addition to excluding the income.
Another benefit is that, since the qualified charitable distribution is not counted as part of your income, it will not be subject to the limitation to charitable deductions on your income tax return – that is, charitable deductions cannot exceed 60% of your adjusted taxable income. Consequently, it is less painful tax-wise to make large charitable contributions in this manner, for those with ample other means of support.
THREE WAYS TO MINIMIZE TAXES ON REQUIRED MINIMUM DISTRIBUTIONS
- One simple step, if the account owner is still working after age 72, would be for him or her to continue making contributions after that age to his or her IRA or 401(k) or similar account, which would provide an income tax deduction to offset income from the required minimum distribution. For example, if a 75-year-old person has an RMD of $5,000 from his or her IRA, and if he or she contributes $7,000 to his or her 401(k) from his or her earnings, the deduction would more than offset the taxable income from the RMD. The age limit for IRA contributions – formerly 70½ – has been removed by the SECURE Act.
- There is another exception for calculating the required minimum distribution for a taxpayer older than 72 who works for a non-profit entity or who works for a for-profit company in which he or she owns less than 5% of the company, if the employer has a 401(k) program which accepts rollovers from IRAs. In that case a taxpayer may be able to roll over his or her IRA into the company’s plan, and thereafter not be required to take required minimum distributions applicable to IRAs from that account until actual retirement from that employer. If you are still employed, you will need to inquire with your employer, to see if you can roll over your IRA to the company’s 401(k) plan and if so, whether you can defer distributions until you retire.
- Another (more complicated) alternative, allowed by the IRS since 2014, would be to purchase a Qualified Longevity Annuity Contract (QLAC) inside your IRA. Many consider an annuity to be a poor investment for an IRA, since both annuities and IRAs are “tax shelters” – and to hold a tax shelter within a tax shelter is a redundancy and wastes the tax benefit of one of the shelters. You get the benefit of only one tax shelter when an IRA owns an annuity.
But the purchase of a QLAC within an IRA offers a different kind of tax advantage: the purchase of a QLAC is a retirement strategy in which an IRA owner can defer a portion of his or her required minimum distributions (RMDs) until a certain age (maximum limit is age 85). A QLAC is an annuity bought with a chunk of money from an IRA now, for payouts starting years later, but no later than at age 85. Money tied up in the QLAC is not counted in calculating your RMD, so the QLAC reduces your required minimum distribution (RMD). Also, it allows the value of the annuity to grow tax-free until you reach the annuity starting age, typically at age 85. Qualified longevity annuity contracts (QLACs) can be bought inside an IRA with (a) up to 25% of the IRA’s value or (b) the amount of $135,000 (in 2020) – whichever is smaller. The annuity would be paid to the annuitant or annuitants for life after the starting age, which provides a guaranteed stream of income which the annuitant or annuitants will not outlive.
The tax benefit of purchasing a QLAC is to reduce income taxes by removing money from the calculation of the required minimum distributions (RMDs) from your IRA after attaining age 72. QLACs are legal creatures created by the IRS to address the fears of many individuals as they grow older, of outliving their money. A QLAC is an investment vehicle to guarantee that some of the funds in a retirement account may be turned into a lifetime stream of income without violating the required minimum distribution rules. The annuity will be paid, no matter how long the individual lives – that is, the recipient cannot outlive the annuity payments.
Annuities provide guaranteed payments to the annuitants during their lifetimes, but at the death of the annuitant (or surviving annuitant, as the case may be) the payments stop. Consequently, an annuity itself is not a good vehicle for passing wealth to persons other than the annuitants. If an annuitant dies (or both annuitants die, if applicable) unexpectedly early, the annuity would prove to have been a poor investment, but if the annuitants outlive their actuarial life expectancies, the annuity may prove to have been a very good investment. Even though nothing would pass to the family at the death of the last surviving annuitant, the annuity payments would presumably allow the annuitant or annuitants to preserve other assets, which would pass to the annuitants’ survivors.
To prevent a total loss of premiums paid for an annuity if the annuitant or annuitants die early, the annuity (including a QLAC), may be custom-designed in some respects to meet your needs. For example, (a) a QLAC could be a joint annuity with the primary annuitant’s spouse, whereby the annuity payments continue for the lifetime of the spouse, if he or she survives, (b) the annuity may guarantee that any unused premium at the annuitant’s death will be refunded, and/or (c) the annuity payments may be adjusted for inflation. Under (b) above, if the annuitant originally paid $100,000 for an annuity, and if the annuitant died before the annuity had paid out $100,000 in total annuity payments, then the remainder of the $100,000 would be refunded.
There are negatives to owning a QLAC in your retirement account. For example, (1) if you need money sooner than originally expected, you could not get payments from the annuity in advance, and (2) your annuity would be only as secure as the company which issued the annuity – so your money would be at risk if the company became insolvent. You need to consult with your financial advisor before embarking on such a strategy.
PROS AND CONS TO ROLLING OVER IRA TO 401(k) – AND VICE-VERSA
An IRA-to-401(k) rollover offers benefits, such as (a) earlier access to the money at age 55 without penalty (as compared to age 59½ for an IRA), and without a Substantially Equal Periodic Payment Plan (SEPP) , (b) postponing required minimum distributions if still working for the employer with the 401(k) plan, and (c) in some instances, easier conversions to Roth IRAs. Also, in some states (other than North Carolina), 401(k) accounts have protections against creditors that IRAs don’t provide; in North Carolina, IRAs are protected against creditors. Also, loans are allowable from 401(k)s, whereas loans from IRAs are not allowed. Generally, you do not want to borrow against your 401(k) account, but, if you have a temporary need which can be repaid in the future, you may, as a last resort, be able to borrow from your 401(k) and to repay the loan with interest.
There are a lot of circumstances where a traditional IRA has a leg up on a 401(k) account, which is why so many people roll their 401(k) accounts into IRAs. Advantages can be wider investment selection, often lower investment costs, and looser rules for hardship withdrawals, without penalty – for reasons such as higher education expenses and first-time home purchase (limit $10,000).
DISTRIBUTIONS AFTER DEATH OF IRA OWNER/PARTICIPANT
It is very important for you to complete the beneficiary designation forms for your retirement account. Sometimes participants fail to fill in the necessary paperwork, or when they do fill in those documents, it is without professional advice. If no beneficiary is named, the default beneficiary is often the participant’s estate. Although naming an estate or trust as a beneficiary may seem logical, you’ve got to be careful. Doing so may subject an estate or trust to unexpected rules and implications, and sometimes imposes them with tax results which might seem unfair or even nonsensical.
Some rules which apply to beneficiaries of IRAs are:
- If a spouse is the beneficiary of the owner’s IRA at the owner’s death, the spouse can “roll over” the balance in the account into his or her IRA, or into a “rollover IRA” opened by the surviving spouse, on which the spouse will be subject to similar distribution rules as an original IRA owner. That is, the RMD will be based on the joint life expectancies of the surviving spouse and an individual who is 10 years younger. If the spouse is under age 72, distributions from the rollover IRA will not be required until the spouse reaches age 72. However, the surviving spouse may take discretionary withdrawals before age 72 and can receive distributions in excess of required minimum distribution (RMD) after reaching age 72.
- If a beneficiary is someone other than a spouse, the account may not be “rolled over” into the beneficiary’s IRA or a rollover IRA, but the IRA may be transferred to an “inherited IRA” account, which is not the same as a spousal “rollover” account. A beneficiary other than a spouse must take RMDs from the inherited IRA account starting the following calendar year, no matter what the age of the beneficiary. That is, the beneficiary of an inherited IRA cannot wait until he or she reaches age 72 before taking distributions. Since annual distributions are mandatory, there is no 10% penalty for distributions from inherited IRAs made to beneficiaries under the age of 59½. Under the old rules applicable prior to the enactment of the SECURE Act effective December 20, 2019 – an inherited IRA was subject to a one-life mortality table instead of a two-life table, and life expectancy was not recalculated as the beneficiary grew older. Under the SECURE Act applicable to accounts of participants who died on or after January 1, 2020, an inherited IRA must generally be distributed to the beneficiary over a period of no more than 10 years.
- On a different related topic, the IRS has not issued guidelines – but there have been several private letter rulings (requiring some expense to taxpayers) – to allow spousal rollovers of qualified plans and IRA benefits when an estate or trust is the beneficiary of the account, (a) when the spouse is sole beneficiary of the estate or trust, and (b) has a general power of appointment over the trust. This can apply where there is no named beneficiary and the “default” beneficiary is the participant’s estate.
In a 2018 private letter ruling, a decedent failed to designate any post-death beneficiary and the plan was payable by default to the decedent’s estate. The decedent had no will, and under state law the estate was split among the surviving spouse and the children. The children were adults with no children of their own and all executed valid disclaimers, leaving the spouse as sole beneficiary of the estate. The IRS approved a spousal rollover in that case.
“STRETCH” IRA STRATEGY
“Stretch IRAs” have been popular for many years as a strategy for slowing down the mandatory payout of IRAs, by designating much younger beneficiaries at the owner’s death – such as grandchildren – to take advantage of their longer life expectancies (and consequently, lower required minimum distributions) than older beneficiaries. Until adoption of the SECURE Act discussed in the following paragraph, an IRA left to a beneficiary other than a spouse was payable over the life expectancy of the beneficiary. That is, if the beneficiary had an actuarial life expectancy of 30 years , the required minimum distribution (RMD) for Year 1 would be 1/30th of the account’s value, for Year 2 would be 1/29th of the account’s value, etc. If the beneficiary died before the account was closed out, his or her successor would continue, on the original beneficiary’s schedule until the account was depleted.
That tactic has been brought to a screeching halt – the SECURE Act, signed into law on December 20, 2019, and generally effective on January 1, 2020, has changed that all, by generally requiring that inherited IRAs by beneficiaries other than spouses must be paid out in no more than 10 years. That is, inherited IRAs left to much-younger beneficiaries will generally need to be paid out in 10 years, instead of over the actuarial life expectancy of the beneficiary. There are exceptions applicable to certain “eligible designated beneficiaries.” If your current estate plan includes a “stretch” IRA, you should go back and re-visit your plan, to see whether it still fits your needs, given the new 10-year payout rule.
An “eligible designated beneficiary” who is not subject to the 10-year payout requirement includes an individual who is (i) the employee, or IRA owner, (ii) a spouse of the participant, (iii) a minor child of the participant, (iv) a person who is disabled or “chronically ill,” as defined in Internal Revenue Code Section 401(a)(9)(E)(ii)(IV), or (v) any individual who is not more than 10 years younger than the participant. But upon the death of the “eligible designated beneficiary,” the 10-year rule kicks in, instead of continuing to be distributed over the remaining life expectancy of the original “eligible designated beneficiary.” When a minor beneficiary attains the age of majority applicable in his or her state (usually age 18 or 21), the 10-year rule kicks in, but a child may be treated as though he or she had not reached the age of majority, if he or she (a) has not completed a specified course of education as described under Internal Revenue Code Section 401(a)(9)-6 and is under 26 years of age, or (b) if applicable, so long as the child continues to be disabled after reaching the age of majority, see Reg. § 1.401(a)(9)-6, A-15.
The new legislation will not affect the terms of payout for original designated beneficiaries of participants who died before January 1, 2020, and it will be applicable only to accounts of participants who die on or after January 1, 2020, subject to the proviso that, instead of continuing to follow an original designated beneficiary’s minimum distribution schedule if the original designated beneficiary dies on or after January 1, 2020, the distribution schedule for any successor beneficiaries will be re-set to a 10-year payout schedule.
A POSSIBLE ALTERNATIVE WHICH SPREADS OUT RETIREMENT DISTRIBUTIONS
An alternative strategy which is still available would be to leave an IRA upon death to a charitable remainder trust (CRT), which would pay a flat percentage each year to the beneficiary or beneficiaries, either for their lifetimes or for a term not to exceed 20 years, whichever the Trust Grantor selects, following rules applicable to IRAs. A CRT is a tax shelter itself, and no income tax would be payable when the IRA was paid to the CRT, but distributions from the CRT to individual beneficiaries of the trust would be taxable to those individual beneficiaries when distributed. In the meantime, the investments inside the CRT could accrue tax-free, perhaps allowing the value of the CRT to grow. At the death of the last surviving beneficiary, the trust would terminate, and the account would be paid to a charitable beneficiary or beneficiaries, as set forth in the trust agreement for the CRT.
Because laws are changed from time to time, and because it is possible for a retirement account owner to become incapacitated, it is a good strategy for the owner to have a durable power of attorney which would be effective in the event of incapacity, specifically empowering the Agent under the durable power of attorney, on behalf of the owner, to change the beneficiaries of retirement accounts and even to create entities such as charitable remainder trusts.
SECURE ACT OF 2019
The SECURE Act was enacted in December, 2019, to expand the opportunities for individuals to increase their savings and to make administrative simplifications to the retirement system. In addition to some of the changes discussed above (moving the required beginning date to age 72 instead of age 70½, permitting deductible IRA contributions after the required beginning date for withdrawals, generally eliminating “stretch” IRAs, etc.), the SECURE Act makes it easier for small businesses to offer multiple employer plans by allowing otherwise-completely unrelated employers to join the same plan, and It also makes it easier for long-time part-time employees to participate in elective deferrals, and it allows penalty-free distributions from qualified plans and IRAs for births and adoptions. Also, penalty-free distributions are allowed from defined-benefit plans or IRAs for the birth or adoption of a child. These withdrawals may be repaid to such a retirement account.
The old rules were not repealed, but the provisions of the SECURE Act were superimposed on the old rules. Consequently, the ins-and-outs of the SECURE Act are very complicated, and there is a separate blog on our law firm’s website which discusses that Act in more detail.